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Inflation, Weathering the Storm

weathering the storm

Central banks are working to curb inflation, and we are beginning to see some positive signs that inflation created by supply chain disruptions is easing while inflation generated by consumers’ excess demand will slow as economic growth continues to slow. Nevertheless, high inflation has created a challenging return environment in 2022. Your team at APCM has prepared for this environment by following our established investment management process.

Batten Down the Hatches

Going into 2021, we faced historically low-interest rates while massive monetary and fiscal stimulus was moving through the economy. Your team at APCM assessed our investment strategies in light of this macro backdrop and proactively adjusted portfolio strategies to increase long-term expected returns without adding unnecessary risk. High-yield bonds were added to increase portfolio returns, as low-interest rates were a headwind for bond returns.  

We consider high-yield bonds a risky asset class similar to stocks, but these bonds are less risky than simply increasing equity exposure. High-yield bonds also have a historically attractive return profile, capturing 55% of the upside when global stocks are positive and 33% of the downside when stocks are negative. From 12/31/20 to 09/30/22, high-yield bonds are down         -5.82%, while global stocks are down -9.45%, performing as expected.  

Given expectations for higher interest rates, we added government and corporate bonds with shorter maturities (1-5 years) to reduce sensitivity to rising interest rates. 

While still negative at -4.44%, they outperformed the broad US bond market, which is down       -9.45% over this time horizon.  

Finally, we knew we needed additional diversification because as interest rates rise, it is a difficult environment for both stocks and bonds. The alternative beta strategies APCM utilizes provide that diversification and are down just -1.66%, easily outperforming both stocks and bonds.

Do Not Abandon the Ship

It is essential to keep a few key concepts in mind when experiencing challenging market conditions: The word “risk” often makes us think of loss, but it is also a source of profit. To earn a return that achieves your specific goals, exposure to some level of risk is necessary. APCM constructs client portfolios with the least amount of risk required to achieve the desired return. APCM projects the returns we expect each portfolio to experience throughout time, both positive and negative. As we move through time, we compare the actual portfolio returns relative to our expected returns. This risk management system prudently monitors and controls risk, which enables us to conclude that despite the difficult 2022 returns our clients have experienced, portfolios are still on a path that has a high probability of achieving the desired returns over time.

The Good Outweighs the Bad

Throughout history, consciously accepting a specific amount of risk and remaining invested even during market corrections has been a successful strategy. Historically, despite intra-year declines of -14%, annual returns of the S&P 500 have been positive in 32 out of the last 42 years. Illustrating why staying the course and not abandoning your investment plan during a downturn in the markets is a prudent decision.  

Plus, there is some good news. This market correction is starting to create value in a few different asset classes. Broad US Bonds are now yielding 4.85% (it was 1.75% at the beginning of 2022) and will be a valuable hedge should the economy fall into a recession. Equities haven’t been this cheap in over 16 years, and small-cap stocks are the cheapest they have been relative to large-cap stocks in over 20 years! Setting the backdrop for attractive returns in the future.

Stay the Course

Your “crew” has prepared for this. This firm has over 200 years of combined experience, and we’ve weathered many storms before. Adhering to our established investment beliefs and following a systematic investment process have been two keys to our investment success. Markets will eventually recover, and the Federal Reserve will successfully bring down inflation.

Unless inflation stays stubbornly high, the current market downturn is very advanced. As we look three to six months out, the backdrop for both stocks and bonds should improve.

Brandy Niclai, CFA®
Chief Investment Officer, Multi-Asset Strategies

&
Lindsey Cashman
Client Relations Manager

10/24/22

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